Description

S.L. Green Corporation (SLG) currently offers an attractive short opportunity.  SLG is a $9.4B market capitalization $21.9B enterprise value REIT that is primarily focused on the Manhattan office market.  2015 was characterized as a year when investors began to question levered structures with highly adjusted earnings, poor cash conversion, and a constant dependence upon capital markets to fund their operations.  While the primary areas of focus in 2015 and early 2016 have been MLPs in addition to “platform companies” I believe that many REITs will now come under increased scrutiny.  The short thesis for S.L. Green is based on the following points:

1.  S.L. Green is statistically overvalued trading at an implied cap rate of 4.13% and uncovered 2.7% dividend yield.  My calculation uses consolidated LTM cash NOI, values the company’s structured finance portfolio at book value, values preferred stock at liquidation value, and includes SLG’s portion of unconsolidated JV debt.

2.  S.L. Green generates minimal CFO and negative free cash flow before acquisitions.  The company is wholly dependent upon accommodative capital markets to fund their dividend as well as their operations.  Street analysts take the company’s spoon-fed FAD calculations at face value and have never actually looked at the GAAP CFO statements which tell a different story.  In 2014 SLG generated $490MM in CFO but negative $47MM in FCF before acquisitions.  If one includes acquisitions, change in non-controlling interests in operating partnerships and adds back property sales FCF in 2014 was negative $250MM.  Using the same calculations for 2013 FCF was $22MM and after acquisitions and divestitures was negative $355MM.  While the company has not yet published a 2015 10K, through the first nine months of the year CFO fell from $377.2MM to $322.9MM.  Below is my core FCF calculation through the first nine months of the year:

Net cash flow from operations                                                                                             +$323MM

Additions to land, buildings and improvements                                                                        - 220

Escrowed cash – capital improvements/acquisition deposits/deferred purchase price              - 117

Investments in unconsolidated joint ventures                                                                            - 127

Distributions in excess of cumulative earnings from unconsolidated joint ventures                + 89

Distributions to non-controlling interests in other partnerships                                                - 113

Contributions from non-controlling interests in other partnerships                                          +  12

Total YTD FCF before acquisitions                                                                                      -$153MM

Acquisitions                                                                                                                              -2,574MM

Proceeds from disposition of real estate/joint venture interest                                                 +1,072MM

TOTAL FCF after acquisitions (9/30/15)                                                                              -$1,655B

Please note that according to S.L. Green’s 3Q Earnings supplement their “FAD” through the first nine months of this year was $315.7MM relative to my calculations above.  In their fourth quarter supplement they note full year 2015 FAD of $338MM and 2014 FAD of $314MM. 

3.  Fundamentals for the NYC office market have peaked and will deteriorate over the next several years.  SLG’s same-store occupancy at YE 2015 was 97.1%, above the 95% level the company has historically asserted is its “peak occupancy.”  In 2015, NYC office-using employment hit a record high of 1.37MM, well above the prior peak of 1.129MM.  Unemployment fell to 4.8%.  In 2015 leasing activity was dominated by FIRE (Finance, Insurance, and Real Estate) at 32% of leasing volumes and TAMI (Tech, Advertising, Media, and Information) at 31.4%.  I believe on a structural basis and cyclical basis financial service employment in Manhattan is likely to fall and much of the TAMI “strength” has been driven by venture capital funding that is currently evaporating.  Additionally, with almost every new significant lease signed in the city employers are using less square foot per employee in an attempt to cut costs and “increase productivity.”  Despite the strong job market in the city, Manhattan office leasing activity fell 23% in 2015 with a marked slowdown in the fourth quarter.  The first indication of a change in market conditions is coming from the VC-driven TAMI sector, an obvious weak link.  Per JLL – “Although only anecdotal at this point, a few tech tenants have already begun to quietly market sublease space as they look to be acquired in what many tech observers predict to be a year of consolidation and slower growth for the industry.”

4.  New supply is increasing.  Combining 2015 and 2016 a total of 9.7MM square feet will come on line in Manhattan.  Between 2010 and 2019 approximately 29.5MM square feet of new office supply will be added.  From 2000 to 2009 net supply added was 12.3MM.  While the supply additions are certainly below the levels of the 60s and 80s, they are elevated versus recent levels and are likely to pressure existing landlords.  Additionally, supply is cumulative.  For those who are superstitious the opening of One WTC marked the completion of the tallest building in the Western Hemisphere.  Over the last 150 years each time a “tallest in NYC” or “tallest in the Western Hemisphere” title has been given to an office building it has coincided with a peak in the New York office market.  The fact that the year-end 2015 opening of 432 Park Avenue marked the completion of the tallest residential tower in the world is also noteworthy for those who believe in indicators of this nature. 

5.  Execution risk is elevated over the next several years for SLG.  In August of 2015 S.L. Green closed on the purchase of 11 Madison Avenue for $2.6B, the most expensive single building transaction in NYC history, adding significant leverage to their balance sheet.  SLG has also begun the largest development in the company’s history – One Vanderbilt, to be constructed at the corner of 42^nd and Vanderbilt Avenue.  The total cost of One Vanderbilt is “estimated” to be in the mid $2 billion range and will not be completed until 2020.  S.L. Green has never taken on this type of development risk.  S.L. Green also announced that Citigroup has exercised its option to purchase 388-390 Greenwich Street for $2B with a closing scheduled for December of 2017.  While this cash inflow will certainly aid liquidity, it will be highly dilutive as the price is an implied 5.75% cap relative to the company’s 4.13% current trading cap.  For what it is worth, S.L. Green effectively “marked the top” of the prior NYC office cycle with their acquisition of Reckson Corp at a 4.9% cap rate closing on January 27^th, 2007. 

6.  S.L. Green has a levered balance sheet and a significant lending portfolio that is vulnerable to losses.  At year-end 2015 total net debt for S.L. Green was $12.5B.  Total 2015 EBITDA was $1.15B – equating to over 10 turns of net debt.  Out of this $1.15B in EBITDA, $181MM is from the company’s structured finance business and $57MM was from “other income” which is generally a grab-bag of one-time gains.  These income streams do not warrant a rich multiple.  The company’s weighted average interest rate on debt was 3.71% at YE 2015 and while maturities are well-staggered the company faces meaningful risk from higher borrowing rates and tightening credit markets.  The widening in CMBS spreads on a YTD basis and the horrible performance of the RE leasing companies confirm the deterioration in market conditions.  Despite extremely low borrowing rates and very low vacancy rates, fixed charge coverage is 2.2x.  S.L. Green’s structured finance portfolio is $1.67B and the current yield is 10.17%.  70% of the portfolio is mezzanine debt at a weighted average exposure of $1,528/psf.  Market deterioration will lead to credit losses.

The bottom line is that SLG is an overlevered, overvalued Manhattan office REIT that is vulnerable due to a peak in the office employment cycle in NYC, added supply, and tightening debt markets.  2015 vacancies were flat and leasing volumes are down.  Transaction volumes in the city, a contrary indicator increased by almost 50% in 2015 with $60.3B in total transactions.  Foreign investment was a dominant driver with record involvement.  JLL notes that foreign investors were 45% of Manhattan investment in 2015 with 45% share relative to 10-20% over the last five years.  Canadian and Chinese investors accounted for 62% of transactions in 2015.  Foreign investors overpaying for office assets at the peak of the cycle is a familiar narrative and I expect the ending to be no different this time.   

Catalyst

Continued tightening in debt markets

Increased vacancy rates

Deteriorating leasing environment

Financial services and TAMI job losses